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Digg's painful lesson: take the money and run while you can

At one point in the no-so-distant past, Digg was one of the hottest
startups on the internet. The Web 2.0 boom was in full swing, and Digg
and its founder Kevin Rose were the poster children for the next
generation of companies that would ride the wave to fame and fortune.

Digg, of course, rose to popularity by providing a platform that
democratized the news. Why rely on editors to determine what's
important and what's not?Let the wisdom of the crowd works its magic.
It was a simple idea, but a powerful one.

Not surprisingly, with Digg's popularity came investors and acquirers. Between 2005 and 2008, Digg was able to raise $40m in funding from prominent angel investors and VCs. And during that time, it was rumored that possible suitors, including Google and News Corp., were sniffing around.

Digg, of course, was never acquired and is still an independent company today. An independent company whose future is arguably far less certain than it appeared to be several years ago. There are a number of reasons for that. The rise of Facebook and Twitter has certainly impacted Digg's position in the market. And Digg was fairly slow to innovate as the consumer internet evolved. The changes it has tried to make in an effort to keep up haven't always gone so well, and the latest round of changes may have put the company's long-term survival at stake.

Today, it seems unlikely that Google, News Corp. or the other tech and media companies that may have had an interest in acquiring Digg before will come back and take a second look. Which must be particularly painful given a revelation Rose made at TechCrunch's Disrupt conference this week in New York:

Looking back. Rose also pointed out that Digg once got an acquisition offer for close to $80 million ($60 million plus earnout) during the site's heyday. While he was personally willing to take this offer, the Digg board decided to turn it down.

Ouch.

Why would Digg's board turn down such an offer? The likely answer provides a lesson from Web 2.0 that veterans of Web 1.0 know all too well. That likely answer: valuation. As one of the hottest Web 2.0 startups, Digg was a desirable target for investors and it's quite probable that they invested at significant valuations. As early as 2006, there was speculation Digg was worth north of $200m. By 2008, when Digg raised its last round of funding, some estimated its post-money valuation at $163.6m.

In other words, Rose, who started Digg with a five-figure sum, might have been happy to take $80m and walk away, but most of his investors probably invested at valuations north of $80m. Even if some invested at valuations south of that number, it's quite possible that an $80m acquisition wouldn't provide a big enough multiple to be of interest. So in effect, a founder who built the right site at the right time wasn't able to capitalize on his opportunity to exit because investors were calling the shots, and it made no economic sense for them.

There are three important lessons here:

You have to strike while the iron is hot. Just because you're hot today doesn't mean you'll be hot tomorrow, and it certainly doesn't mean you'll be hot five years from now. While selling out too early is a concern, the reality is that the majority of the promising startups that have been launched over the past decade didn't grow into billion-dollar behemoths, didn't get bought out for hundreds of millions (or billions of dollars) and didn't gone public. That doesn't mean they weren't successful companies. It just means that almost every company reaches a point at which its valuation can't go anywhere but down. The implication: it's often better to risk sellingearly because you may not get a chance to sell later. The hint you may have reached your peak valuation: you're on the cover of magazines as the $60m kid and your company hasn't yet made a cent of profit.

Investors can impede good exits. When you have equity investors calling the shots, you may not be able to strike while the iron is hot. Thanks to board control and liquidity preferences, investors are oftenable to put their economic interests before those of founders.

Sometimes less is more when it comes to valuation. The economic interests of founders and investors are most likely to diverge as valuations rise. After all, a founder who started a company with $10,000 would probably be more than happy to take $80m and run after just a few years of work. But when investors have poured millions into the same company and valued it at tens of millions of dollars, $80m may not cut it. From this perspective, founders should consider that higher valuations may allow them to raise more money with less equity in the short term, but they often prevent the company from exiting because investors are liable to overestimate the company's long-term potential and pay too high a price for their equity early on.

Will Digg ever get a second chance at selling? Perhaps, but almost certainly not at the kind of price it could have commanded years ago. If there's any good that can come out of Digg's loss, it's this: Digg's story just might serve as a powerful reminder to future founders about how fleeting opportunity really is. Maybe a few of them will even consider Digg when 'Web 3.0' hits and they have to make funding decisions.

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Comments (5)

Ross Kendall, Web Developer at Ross Kendall

What ever happened to businesses that have as their goal to be successful by providing good products and services?
People who run or invest in businesses with the goal of being bought out are leeches that are contributing to the demise of society.

Providing a good product/service and being acquired are not mutually exclusive. In fact, it's pretty tough to get acquired if somebody else doesn't think you have a good product or service.

Is being acquired more desirable than running a profitable business long-term? In some cases, no, and in others, yes. It depends on the circumstances, and the amount of money being offered.

It's important to note that acquisitions can be an important part of capital formation. If you, for instance, start a company for less than $100,000 and are able to sell a few years later for even a few million dollars, chances are you will invest that money in something else. A new business of your own, someone else's business, etc.
From what I understand, Digg's Kevin Rose has been able to take some money off the table over the years, and guess what - he's an angel investor and if he's lucky, his money will not only grow but it will help other entrepreneurs achieve financial success of their own.

As rightly mentioned by Robles, acquisition need not be the ultimate motive for an entreprenuer, it is an opportunity. Important factors like financial position, nature of stakes (% of internal & external stakeholders) in the company would decide whether to stay independent or sell.
Janaki

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